The eve of destruction
Another fine mess at UBS
To explain the concept of leverage, one hedge fund operator uses the analogy of a racing car: "If you go out and have four vodkas and drive a race car on the city streets, you're gonna crack up and get hurt more than if you're driving a Chevy. And a lot of people have been driving irresponsibly lately."
"Leverage can kill you," admitted an official at the New York Federal Reserve Bank, shortly after the Fed had hosted the rescue of Long-Term Capital Management, which had levered around $4 billion of capital into more than $120 billion on its balance sheet and several times more off balance sheet, before it threatened to spin out of control and take every other car on the road with it. Says Henry Hu, a banking and finance law professor at the University of Texas: "The scary part about LTCM is that it suggests that the world financial system has more structural flaws than any one country".
As it turned out, during the recent dizzying bull market the most sophisticated players in the system had become over-reliant on value-at-risk (VAR) models, mark-to-market valuations and the margin collateral these valuations dictated. It is now clear that these are virtually useless in times of market crisis at presently accepted levels of leverage. While paying lip-service to the benefits of stress-testing, it now appears that few had done enough in this area.
"These systems were either flawed or not fully implemented at some firms," says Moody's Investors Service bank analyst Les Muranyi. Federal Reserve Board chairman Alan Greenspan, speaking before a US Congressional banking committee hearing on hedge funds after the LTCM crisis, questioned "how much dependence should be placed on financial modelling" as he told legislators there was nearly a 50% chance that a collapse of LTCM would have roiled the rest of the financial system.
As an example of the kind of exposure that frightened the Fed, Merrill Lynch, arguably the world's premier financial institution, found itself with a mark-to-market exposure to LTCM of $1.4 billion, almost a third of the investment bank's tangible equity capital of $4.3 billion at the end of June - although in normal markets that was fully covered by high-grade collateral. In September's abnormal markets Merrill, like others, was worried about being caught short of collateral and was fearful of calling for more - in case that brought down the whole house of cards. Merrill chief credit officer, Robert Murphy, defends the exposure: "It is fully collateralized by cash and government securities, our net exposure [based on current market prices] is zero. That's the real number to focus on."
The firm declined a request to appear before the Congressional hearing on hedge funds as did other institutions involved in LTCM's rescue. But after Merrill reported its first quarterly loss in nine years last month, its top risk manager, Daniel Napoli, took leave of absence, and Merrill reorganized its risk management division to closer integrate credit risk and market risk management. A spokesman says the changes were not related to LTCM, nor does it indicate that previous risk management practices were inadequate.
Too few questions
The banks have been criticized for not better understanding LTCM's precarious position and for relying on the star power of former Salomon arb king John Meriwether and options-pricing Nobel prize winners Myron Scholes and Robert Merton. While the specifics of LTCM's trades may have been unknown, its high leverage should have come as no surprise. In its original prospectus, LTCM warned investors it would employ "tons of leverage and have a lot of volatility in earnings," says Leslie Rahl, a principal at Capital Market Risk Advisors, a New York consulting firm that specializes in derivatives.
Moreover, the 40-60-to-one leverage LTCM maintained until late summer was not uncommon for fixed income and currency hedge funds, says Lois Pelz, the editor of MAR-Hedge, which analyzes the industry. According to US representative James Leach, chairman of the House Banking and Finance Committee, about a third of hedge funds are highly leveraged. Moreover, the effects of the leverage are amplified by the borrowing from financial institutions, themselves also highly leveraged. As for LTCM, its leverage ballooned as it ate through capital after June, unwinding losing positions.
Much has been made of the fact that hedge funds like LTCM aren't regulated. But then neither are the subsidiaries where most of the investment banks booked their trades with it and other hedge funds. SEC director of market regulation Richard Lindsey says that most of the activity of the US securities firms' exposure to LTCM was outside the regulated broker-dealer, either in the holding company or its unregistered affiliates. On the other hand, banks regulated by the Fed are subject to more oversight. While the derivatives activities are typically not booked in the bank, they do fall within the bank holding company, which is subject to Fed scrutiny. Given the existence of universal banks in Europe, those institutions' derivatives books are also under the scrutiny of bank regulators.
An estimated 5,000 hedge funds, with $200-$300 billion in investment capital supporting assets of about $2 trillion, trade with the investment banks. In this gentleman's club, it's not so much a world of lenders and borrowers as one of trading counterparties. And today, as risk perceptions have risen, some hedge funds are as wary of their investment bank counterparties as the banks may be of them, say hedge fund advisers.
As soon as LTCM became front page news, bank after bank sought to allay market fears by releasing information about its exposure to hedge funds. Chase acknowledged a $3.2 billion exposure, which comes to approximately 13% of its tangible equity, Morgan said it had $900 million (8%), Bankers Trust reported $875 million (17%), Lehman Brothers had $447 million (8%) and BankAmerica had $400 million exposure (1%), not counting the losses associated with its equity investment in hedge fund DE Shaw. With its plans for becoming a public company shelved for the moment, Goldman Sachs, who along with Merrill and JP Morgan had led the LTCM rescue, was able to avoid disclosure, though bankers say they believe its exposure was higher than Merrill's $1.4 billion. Citigroup, the just-merged financial institution including Salomon Smith Barney, hasn't disclosed its exposure either.